SEC Proposes New Rules Regarding Performance Fees

On May 10th, the U. S. Securities and Exchange Commission ("SEC") issued a proposed rule that would raise the performance fee eligibility thresholds of Rule 205-3 under the U.S. Investment Advisers Act of 1940 as amended ("Advisers Act"), to $1 million in assets-under-management ("AUM").[1] If the proposed rule is enacted, a client will have to have $1 million (increased from $750,000) in AUM with the adviser or $2 million (increased from $1.5 million) in net worth. Section 205(a)(1) of the Advisers Act generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. However, Section 205(e) of the Advisers Act authorizes the SEC to exempt an adviser from the performance fee prohibition if the SEC determines that the client does not need the protection of the prohibition. In 1985, the SEC adopted Rule 205-3 which exempts an investment adviser from the prohibition against charging a client performance fees if the client has at least $750,000 under management with the adviser or if the adviser believes that the client had a net worth of $1.5 million at the time the investment advisory contract was entered into. Under the proposed rule, the AUM threshold would be raised to $1 million and the net worth threshold would be raised to $2 million. Clients who are "qualified purchasers" or "knowledgeable employees" will continue to be exempt under the proposed rule. Additional proposed changes to Rule 205-3 include the following:

1. The SEC will issue an order every five (5) years adjusting the dollar amounts for inflation;

2. Exclude the value of a person's primary residence from such person's net worth to be considered a "qualified client" (similar to the recent changes to the definition of "accredited investor"); and

3. "Grandfather" adviser's existing contractual relationships.

The SEC is seeking comments on the proposed rule on or before July 11, 2011. If you have any questions, please contact Daniel G. Viola at 212.573.8038 or

[1] See Investment Adviser Performance Compensation, Advisers Act Release No. 3198 (May 10, 2011),

Cheryl Spratt